The Startup CPG Podcast

Gabrielle McGonagall
If you are still an employee, there's typically something called a cashless exercise, which means upon a sale you will get distributions as if you owned those shares less whatever your exercise price is. So if you are there at the time that there's an exit, typically you will get the benefit of owning those shares and they'll just reduce it by whatever your purchase price would have had to be. You go into this hoping that you're going to have a great long term career at this place. Maybe it doesn't pan out the way you want and now you've taken certain compensation that you thought was going to be really valuable. And maybe that's not so much the case when you go to exit. From an employee or an advisor standpoint, there's a little bit more risk there.

00:55
Gabrielle McGonagall
From a company standpoint, it's sort of making sure that it's like, hey, you're going to get the benefit of this if you're around when we go to sell this thing.

01:04
Daniel Scharff
Welcome everyone to a very important episode of the Startup CPG podcast. We're here talking about how to structure your company, what kind of entity, where should it be, how do you issue equity, what are the mechanics of a fundraise, and so much more. We are joined by Adam Marsh and Gabby McGonagall from Gianuzi Lewinden. It's one of the best known firms in our CPG world. They work with disruptive high growth consumer products companies through every stage of their business life cycle. So from inception all the way through to growth and then hopefully acquisition. All right, everyone get out your legal pads and start taking notes because here we go. Welcome everybody. I'm here with the team from Gianuzi Lewinden today, one of the absolute best known legal firms in the space. They work with over 1,500 secret clients.

01:54
Daniel Scharff
That's mainly going to be in food and beverage, personal care, beauty, pet, alcohol, all that stuff. They do a hundred equity and debt financing deals per year and also help sell 10 to 15 companies a year, probably a lot of the ones that you hear about. So first of all, do you guys mind maybe just introducing yourselves, let us know who you are and what do you guys do. How do you help a lot of companies in the space?

02:18
Adam Marsh
Sure thing. I'll, I'll start us. And thanks for having us, Daniel. It's a pleasure to be here lovewatch, listening to your podcast. So I'm Adam Marsh. I've been at the firm since 2013. It's actually my first job out of law school and so for better or worse, all I know is cpg, all I know is food and beverage. And all I know is representing founders and management team as they grow, scale and exit companies. So whether it's a convertible note financing that we'll talk about today, a large scale exit now building the assets of your company. That's what I've done my entire legal career, for better or for worse. But I wouldn't have it any other way. The founders we deal with are fantastic. The industry is exciting and energetic. So yeah, that's a little bit about me.

03:03
Gabrielle McGonagall
I'm Gabby McGonagall, also followed along with Adam three years after and have been sort of tagging along ever since. Similarly, CPG is all I know. I was really interested in the firm from the beginning just because I didn't know that there was a law firm that would be working so closely with brands. That certainly is what drew me in. And working with the founders is what keeps me sticking around.

03:26
Daniel Scharff
So let me just ask you guys this because I have a sister who is a lawyer. She went to a good law school and then she went to one of like a kind of classic law firm and put in her time. She eventually left and went to go, you know, work for other companies. But I feel like for her friends that I knew they were all kind of doing more standard law firm stuff. You guys seem to do the fun stuff though. Like do your friends from law school look at what you do? And they're like, man, I wish we could kind of do that. We're stuck at these like, you know, scad, narp, whatever, like you know, corporate, all that kind of stuff. What do they think?

03:59
Gabrielle McGonagall
Yeah, I mean we in my sort of post grad group, I'm referred to as the one doing happy law. Particularly we don't do any litigation. So that keeps some of that away. But I think a lot of the fun of it is the people that we get to work with. Contracts are contracts. There's some of it. It's like if you negotiating for elevator parts or produce, you know, some of it's just it is what it is in terms of the legal drafting. I think one of the things that keeps things so interesting is with these founders, they're so creative, they have different ideas. It's interesting for us to sort of learn from them too what their idea of creative solves are sort of thinking outside of kind of the legal box.

04:37
Gabrielle McGonagall
And then over the years have accumulated so much knowledge from them and also able to impart that on so many of the New founders that we work with.

04:44
Adam Marsh
It's funny that you call you that. My friends call me the snap lawyer. But, yeah, you hit the nail on the head. It's all about the industry and the people that you meet doing events with you. Daniel, like, it's always such a pleasure. And that's what keeps us coming back to work every day.

04:58
Daniel Scharff
Right? I like to hear that because CPG is fun and I think that's why so many of us are drawn to it. So I'm glad that applies to lawyers as well. Okay, so I'm excited to just get into it today because all these questions, we get all the time on the slack that I think you guys can just answer for everybody if we just go one by one. So I want to ask you all about really the early stuff, like setting up your company and figuring out how you're going to fundraise for it and how should you structure all that stuff? Because I think the knowledge is low and the implications are high. So let's just do it and get everybody that good info.

05:32
Daniel Scharff
So then when they do have to start paying you guys, they at least already have a good knowledge base to start with. Let's do it. So first of all, tell me about entities, because there are a bunch of different ones out there. Startups. EBG is an S corp. I don't know. I honestly don't really even know if that's the perfect thing or not, because I never talked to anyone like you. But can you tell me about the different kinds of entities and what are the implications of that?

05:55
Adam Marsh
Well, if you're going to be an S Corp, it makes it a little more challenging to bring out investment. So that would be my one piece of advice for you. But, you know, most of our clients, they tend to be either LLC or C Corps, and there's no, you know, magic behind it. I would say that, you know, llc. That structure ultimately gives you a little bit more flexibility. There's less, like, corporate rules and structures under the Delaware Code, you know, you have to have board meetings or shareholder meetings, and there's just more rigidity in a corporation. So that's one reason people tend to like LLCs. They also can utilize startup losses more quickly so your cash investors can actually take deductions if your company's not making money. Another positive is you can issue what are called profits, interest in the corporation.

06:42
Adam Marsh
You issue stock options, but again, that's just a little less tax beneficial for your employees. Or if you're bringing out a co packer and you're giving them equity for services, the profits interest tends to be slightly better from a tax perspective. And of course you avoid double taxation. Right. So an LLC is a pass through entity. So if and when you're making money, a corporation gets taxed at the corporate level and at the holder level. So you don't have that at the llc. And then on a potential sale there are what's called a step up in basis. So sometimes you can actually increase your purchase price because of that. That's a longer term issue, but it's a good one to have in your back pocket in the event of eventual sale to, you know, Coke, Pepsi, Mars.

07:27
Daniel Scharff
Okay, so for an early brand, you know, maybe LLC is okay in the early days, maybe later on, you know, it looks like, hey, there's some momentum, there's some real money that's going to come. And they can always convert it, I think also to a C corp. Yeah, go ahead.

07:40
Adam Marsh
Yep. That you could convert to a C corp, but then you still can use this QSBS treatment which is, can be incredibly beneficial. It's, you can exclude 100% of the gain from your sale of stock to the greater of $10 million or 10 times your basis in that stock. So that could be a substantial tax savings down the road. So that's often why you see once private equity comes in, that they want to convert you to a C corp so they can take the advantage of the QCBS treatment.

08:10
Gabrielle McGonagall
Sorry. One thing to note, it doesn't mean that you're going to have to convert to an llc if you're an LLC and you're doing well and you have investors coming in, we see plenty of times investors coming in happily to an LLC structure. So it's certainly not the case that you have to be or should be a C corp if you think you're taking on strategic money. Because we do see both. But, but that was just more kind of like the initial pull for C corp structure.

08:33
Daniel Scharff
Okay. And is there anyone else that you would actually recommend the LLC to besides, let's say someone who just isn't really swinging for the fences in the early days and maybe that would just be fine for them. Anyone else you'd be like, yeah, you probably would think about this.

08:46
Gabrielle McGonagall
I love the LLC structure, particularly for founders. Kind of what Adam touched on earlier. Lot more flexibility, lot more sort of, you know, even things that you won't think of at a corp level, like written consents for a lot of different actions, big and small. You want to issue incentive Equity to certain people. You want to expand pools. There are certain statutory requirements about getting certain shareholder approval. Those don't really exist in the LLC structure. You can contract for a lot more of that stuff. So I think the pass through is a big one because again even most cpg, or maybe not most, but particularly beverage, it takes them a long time to become profitable. Even really successful companies are still benefiting from being able to write off their losses in the pass through structure.

09:35
Gabrielle McGonagall
So I think there's still a lot of long term benefits for an llc, not only administratively and being able to just sort of have a little bit more flexibility in your governance but even just long term economic benefit, what.

09:47
Daniel Scharff
Does that mean exactly? Writing off a loss in a pass through structure. So let's say I'm in an llc, I have my beverage company and year one, you know, we lose a hundred thousand dollars. That means, I think that I can, if let's say I'm the sole owner of the LLC, that I could take that entire 100k on my personal taxes then that way. And so if I'm paying myself something, basically that's all going to come off against my salary, stuff like that, to reduce my overall personal tax rate, is that right? I don't really know so.

10:18
Gabrielle McGonagall
Well, there's a difference between your salary and potential like income tax that you owe on that and also other sort of like withholdings relating to that. This is more in connection with your equity stake. So when you're looking at being taxed on this asset that you have, and this asset has value because you own a piece of a company, when you're looking at that value of the company and what your percentage means with respect to your take home value and your income in connection with that equity, that's where the deduction comes into play.

10:50
Adam Marsh
So to your point, if you own 100% of the company, that tax that boss would be passed through to you. So you could write that off as part of your tax return.

10:58
Daniel Scharff
And then if you have like even outside investors basically at the end of the year and you have an llc, you would be telling all of them like hey, here's what happened on the P and L this year and we lost 100k and you'll be able to actually deduct 10k of that because you own 10% of the company investor, something like that.

11:16
Adam Marsh
Yeah, for the cash investor, the investor who actually put in money. That's correct.

11:21
Daniel Scharff
Got it. Interesting. All right. Shows you all what I know about fundraising. Never personally done it. Okay. So I Got it. So C Corp, you know, maybe some greater flexibility there, but probably more red tape. Also, you're going to have to get things signed, get things done. I've definitely had to sign some stuff like that where I'm like, gosh, really? Like, you need me to sign this thing? I don't care about this. So. Okay, that makes sense. Okay. And then the qsbs that you mentioned basically is just a way to protect from taxes up to 10 million of your ownership stake. How do you do it again?

11:57
Adam Marsh
Yeah, so it's, you get to exclude 100% of the gain from your sale of stock to the greater of 10 million or 10 times your basis in the stock. So if you have a basis of the stock, that's 10, like suppose you've started with a LLC and you converted that to a C Corp. In your basis in that stock upon conversion is 10 million. You can write off $100 million upon an eventual exit. Now, there's a few more details in there. You have to hold a stock for like five years and all that, but that's the Cliff Notes version of it. So that's why, you know, investors come in and they love this. Right. Because that's like, that's a windfall for them that they wouldn't have had under a different structure.

12:36
Daniel Scharff
But you have to do like, do something to kick that off, like file a form at the beginning or it's just something you can do in retrospect.

12:43
Gabrielle McGonagall
No, you don't have to file anything. That one key note is that once a company has more than 50 million in assets, any stock that they issue after that is not going to be QSPS eligible. So early stage C Corp, before it's like really hit its mark and doesn't have that high value, that's where all of those issuances are going to automatically have that QSPS treatment. Once you sort of cross that $50 million in asset threshold, the issuances aren't going to have that treatment.

13:15
Daniel Scharff
Okay, I gotcha. All right, so let's say now I know what kind of entity to form, where should I form it? Because I think everyone who doesn't know this, like what we hear about Delaware, which is where startup CPG is formed, but I don't know, there are some other companies that form in the state that they're in or you know, where they have some business. So what do you typically tell companies?

13:38
Adam Marsh
I think nine times out of 10 we're going to tell them Delaware, if you're Coming to me with a fresh idea. You don't even have a company. We're going to form it for you. We're going to form it for you. In Delaware, you know, people come to us all the time, right. They're formed in New York, they're formed in California. And more often than not, when the investor comes in and wants to give you a million dollars, $2 million, $5 million, one of the requisites is going to be you have to convert to a Delaware LLC or C Corp. Now, we are seeing a few changes. There's been some talk of Texas and Nevada and we've seen a few companies incorporate there. But generally speaking, Delaware is the rule.

14:15
Adam Marsh
And that's because there's so much, frankly, case law there and there's so much, you know, that's already been determined in those courts. So you're not going into there with like your eyes closed, kind of. Everyone knows what to expect. And in this industry, when you're an investor, you want clarity, you want to know the rules of the road. So that's why more often than not, you're going to be in Delaware.

14:36
Gabrielle McGonagall
Yeah. And one thing is, it really is like Adam was saying, a matter worst case scenario. You know, when you're getting into contract disputes or investor disputes or some sort of claim, that's where that case law comes in because it allows you sort of going into things to do a better risk analysis. There's a better guess at what the outcome is going to because they've been litigated so much. I think the only other thing I would note, one other state that we've seen a little bit is Florida. If you're actually operating there because of the tax benefits there, obviously if you're mainly working out of New York and you incorporate in Florida, you're not going to have that benefit.

15:19
Gabrielle McGonagall
But for those who are actually like Miami based or otherwise in Florida, that's kind of the one that we don't usually talk people out of.

15:26
Daniel Scharff
Okay. But pretty much anybody can incorporate in Delaware. Delaware, which is one of the states that has that advantageous tax status, like similar, I think, to Texas and Florida and Tennessee and Vermont maybe, I don't know, I'm just saying those, but I think maybe it's right. So. Okay, but that makes sense. So Delaware just. It's kind of what people do. And there's been so much litigated there that everybody kind of knows the rules of the road and they know what to expect if there's A problem. So they like to do business there because once you know everything, people kind of know how things will go. And maybe you don't even have to litigate as much because you can all look at what actually happened in the past and maybe not waste all that money.

16:05
Daniel Scharff
So one question that I really like to ask, like, it wasn't until I did my first entrepreneurial thing, which did not go anywhere, that I realized how important it is to figure out equity, you know, between co founders. Early on, like, I think a lot of people go in and they're like, well, we'll just split it and then you might never be friends again. As soon as one person is not pulling their weight as much as the other person and you don't have something that actually gives you a guide for how the equity is going to vest, all that stuff. All right, so once you form the company, like you as the founder or the co founders, you just kind of have all the equity, right?

16:39
Daniel Scharff
You, like form the company, you issue the equity to yourself and then like, what's going to happen over time as you grow this thing and other people come on board?

16:48
Adam Marsh
So let's just use Gabby and I as an example. Gabby and I start a cricket bar company, right? So, you know, unless we have a different arrangement, because I came in with a lot of ip, or I plan to work seven days a week and she's only going to work two days a week, for simplicity's sake, let's just say, you know, we're going to split it 50. But then the key is, right, to have a document, whether it's an operating agreement, a shareholders agreement, some sort of agreement that's going to kind of govern our relationship, right? So it's the two of us. Do all decisions have to be made by unanimous approval? Do we want to have a third outside independent director? And it can be made by 2 to 3 vote. So these are the things you kind of want to consider.

17:28
Adam Marsh
And you know, most people at an early stage, they say we're going to best friends forever, right? We're going to be a lockstep, we're going to make all decisions together. And frankly, that often works for a long time. But as the company continues to grow and expand, you know, you bring in outside advisors, you bring investors, the structure of the company will change. You also want, may want to incentivize yourself and employees, right? So we kind of talked about earlier, you have a stock option plan or an incentive unit plan whereby you can issue equity to your head of sales Your head of operations. Right. Or maybe an investor comes in and says, you know, Adam, you're getting too diluted.

18:07
Adam Marsh
I want to issue you some stock options and that'll vest over, you know, call it four years so that I'm still incentivized to work. And maybe at that point, Gabby stepped away, or maybe she's doing way more than I do and she should get even more equity or less equity. And that's kind of just the evolution of how these businesses grow and run.

18:27
Daniel Scharff
So that's pretty interesting. You know, I never really thought about that also, as I guess it's an ownership question. Like, yeah, if somebody goes into this with a co founder and people invest in the business and then there's just some thing that they really do not agree on without this kind of a document, like, how do you actually even resolve that? Like, they just think, A, the other person thinks B, neither one of them compromise. So it makes sense that maybe if you have that detailed out in a document, at least it's clear what happens in that instance.

18:54
Gabrielle McGonagall
Yeah, for sure. I think the other thing is CPG is, if you ask any of our founders, it's all encompassing. It's your whole day to day, your nights, your weekends. I think, fortunately, most cases where we have more than one founder, there's so much dedication, there's so much put into these companies that overall, they're always sort of aligned on the end goal or why they're doing it or why they got started. So we luckily don't see a ton of founder fallout. And if we do, there's often some acknowledgment of like, hey, I can't commit to this anymore, or things in my family have changed. I'm really looking to be bought out. You know, I think I need to exit this, and then you can kind of work to amicably solve something.

19:40
Gabrielle McGonagall
Very rarely do we see a situation where Adam and I are both getting 100% and we just hate each other so much that we can't keep operating. So luckily that hasn't happened. I think it's also very unique in CPG because I think most people do not go into CPG to make millions. Hopefully, that's the happy byproduct. But I think people are going in because they have a passion for creating something that they felt was sort of missing in the market. And it takes so much work before you're at a point where you're really even potentially making a good amount of money from it. It doesn't seem to be what really drives our founder group.

20:19
Daniel Scharff
I gotcha. Okay, so that makes sense. I hope everybody does make millions. But it is a tough business. And I see what you're saying about like, yeah, it's not so often that everyone's just putting in a hundred percent and then can't agree on stuff. It's more like Facebook movie. Eduardo left business. They're like, come on, bro, you're not committed, we want you out. Okay, I got it now. So what happens as you start bringing people on? Right. A lot of businesses want to be able to offer equity maybe to employees coming on, you know, have that as part of their compensation. How does that act and like for employees and also maybe some advisors as well. How does that actually work?

20:58
Adam Marsh
Yeah. So to your point, you know, a lot of these emerging brands don't have lots of money to pay employees. Right? So part of the incentive structure is, hey, you know, you're going to grind, but we're also going to issue equity in the company so that you can achieve some of the upside if and when we sell. Sell, Right. So again, two structures. There's incentive units for analyze stock options for a C Corp. But yeah, the management of the committee effectively will, you know, issue me 1% of the company. The CEO maybe gets 5% of the company and again, their payment, their, you know, their salary might not be as large as they might have if they work for a larger corporation like a Coke or a Pepsi.

21:43
Adam Marsh
So that's how you get these guys to grind day in and day out to pound pavement, to go in all those bodegas in New York to sell the product. So the way this is done, it's pretty simple. Now you, whether it's a board or a management committee, they can just vote, right? You just, you'll sign a consent and you vote and say, hey, Gabby, she should get 2% of the company. And then typically there's a vesting structure, right? So in our industry is usually over 4 years. Can be monthly, it can be quarterly, it can be yearly. And then when you want to incentivize, as we talked about earlier, like maybe a manufacturer, you want to get a lower price for your goods.

22:18
Adam Marsh
So instead, you know, paying what they would expect, you're going to pay half that and they're going to get half their compensation and equity. So you see that kind of structure all the time. And in those scenarios, right, if you're onboarding a manufacturer or distributor, you just have to be sure that the terms of those contracts, right. Allow you to get out of Those agreements and for that equity to stop vesting, the worst case scenario would be is become unhappy with their manufacturer. You leave them after two years, but their equity continues to vest for four years even though you're not using them. So you know, you'll have to get alignment between the grand agreement, in this case the manufacturing contract. But again, that's a great way for smaller companies to reduce costs.

23:00
Gabrielle McGonagall
Other plus to that is not only are you giving employees or advisors a potential upside in the business, but like Adam was talking about, the vesting can be very tailored. So it's also a way for the company to protect itself. Because you could say, hey, we're going to bring on this sales guy. We think you could be great, but this is going to best based on us hitting certain revenue or sales targets. And so it's also a way to protect against sort of like, hey, we're going to give you a potential great upside, but we don't know you yet. We don't know how you work. We don't know how successful and how much value you will really add.

23:33
Gabrielle McGonagall
So it can be used as a tool not only to incentivize good work, but also to protect the company if they're not really getting what they need to out of that relationship.

23:43
Daniel Scharff
Okay, I hadn't really thought about that. I mean, I'm familiar with vesting that might have like a cliff. You know, hey, this doesn't even start until you've been here for a year. But that's actually new to me just to hearing that you can do it based off hitting certain thresholds and targets and their personal, you know, sales commission or the company targets, stuff like that. So once upon a time, I joined a company and I was issued shares at a $6 valuation. And what I learned that meant is, here are the shares, they're going to vest over time. So you're going to get thousands or tens of thousands of shares every year. And then these are actually options.

24:20
Daniel Scharff
And so if you ever want to exercise these options, it means then you pay us $6 per share and then you can sell them, I think, sometime later and whatever you can get for them. Right. And so it actually made it kind of hard to leave the company because you would have to give out the money. So let's say you had 20,000 shares. That's 20,000 times $6. So $120,000 you'd have to pay to take those shares without really even knowing if you could sell them yet or if they'd be worth more than that. Because the company actually had a very high valuation when most people joined. And so it wasn't clear like, hey, it could go to the moon or not, I don't know. So. And that's just a lot of money to put out.

25:04
Daniel Scharff
You know, if you're not a very rich person, is that pretty common or what do you see most people doing? How does it go?

25:10
Gabrielle McGonagall
Yeah. So this is kind of what Adam was talking about earlier with sort of the profit interests in an LLC versus the stock options at a corporate level. Which is why again, Adam is sort of saying the profit interest is the best way to incentivize people. There's no exercise price. There's something called a distribution threshold that has sort of a similar concept where you're only going to make money over a certain amount, but there's no buy in that you need to make with the option. You do have to exercise it. The kind of flip side of it is hopefully if you are still an employee, there's typically something called a cashless exercise, which means upon a sale you will get distributions as if you owned those shares less, whatever your exercise price is.

25:58
Gabrielle McGonagall
So if you are there at the time that there's an exit, typically you will get the benefit of owning those shares and they'll just reduce it by whatever your purchase price would have had to be. To your point though, it does kind of get you stuck in there because if you do want to leave, most I think have somewhere between like you have to exercise between 90 days and a year upon like after an exit. So that does kind of make it tricky. You know, you go into this hoping that you're going to have a great long term career at this place. Maybe it doesn't pan out the way you want. And now you've taken certain compensation that you thought was going to be really valuable. And maybe that's not so much the case when you go to exit.

26:38
Gabrielle McGonagall
So from an employee or an advisor standpoint, there's a little bit more risk there. From a company standpoint, it's sort of making sure that it's like, hey, you're going to get the benefit of this. If you're around when we go to sell this thing. If you want to cut your losses and you don't want to stick around until we get to that point, then you need to kind of invest like everybody else does to have a piece of the pie.

27:00
Daniel Scharff
Yes. So I think, you know, just tying this back to, hey, you're a founder, what kind of equity do you want to actually give out to people Those are the things to think about. Like your employees are going to prefer it if they can just get the equity. You probably would prefer it if there's something tied into that. So like, yeah, sticking around. So how do. What do you actually tell people when they're starting to issue or, you know, create an employee stock pool or whatever? What is that? Like, how do you actually recommend it to them?

27:26
Gabrielle McGonagall
Yeah, one quick note on that. You can still have a profit interest that says in order to receive any proceeds for this, you need to be here at the time of a sale. So I just wanted to clarify that the profit interest grants can still very much require you to stick around. There's just not that purchase price that we talked about in terms of how and when to incentivize people. I mean, I think at any given point we usually advise that companies have a pool of somewhere between 10 and 15% of the overall ownership structure. Some of that at some point will be, you know, heavily issued, some of it won't. We had body armor, which Mike Rapoli, who's a repeat renowned founder in the space, his whole mantra was always to reward the people who helped build it.

28:12
Gabrielle McGonagall
So we, that was the largest pool that we've ever seen. I think it was somewhere either the high 20s or low 30%, because that was really important to him that everybody who helped build it was going to have some real benefit upon an exit. So they're obviously outliers, but we do, I think, typically see an overall kind of pool of around 10 to 15%. And remember, when new money comes in, it dilutes everyone who's already there. So that pool might shrink. Maybe it was 10% of the structure and then there's a big investment and it shrinks down to 5%. That's why a lot of times you'll see this kind of re upping of that pool to get back to around 10 to 15%.

28:52
Gabrielle McGonagall
And yeah, I think it really depends in terms of what stage you're at, in terms of what you need, what kind of level of expertise. Typically for early stage companies, employees, even if they're sort of higher role, you're still seeing somewhere around like 2, 3%, if not lower. Like some rank and file sales are going to be lower than that. There are times where we've seen companies gearing up for an exit. They need a really sophisticated CFO who's done this before, who has a ton of experience. And maybe that percentage ownership is a little bit higher because it's sort of very specific and a crucial need at a crucial point in time. So there's not really like a clear rubric on it.

29:33
Gabrielle McGonagall
I think whenever clients are sort of debating how and when to issue, we like to have a larger kind of conversation with them about what stage they're at, what need they're really filling, and who this new potential grantee is and how they're gonna help drive that success.

29:49
Daniel Scharff
I gotcha. Okay, very helpful. So I wanna get into actual fundraising a little bit. So when you're like, it's hard to fundraise, we know that, but in theory that's something a lot of people wanna do. And can you just tell me a little bit about, like, how do you get started doing that? Okay, I know I wanna raise money, like need to do at this point to make that possible, you know, given that I've already formed my entity and, you know, the way you guys have suggested. Yeah. What's next?

30:18
Adam Marsh
I think you should start earlier than you think you need to. No, just given the environment we're in now, it's a challenging time. There's a lot of chaos happening. So starting early and getting your ducks in a row is important. And then I think you have to think about what kind of structure you're going to do. Right. Are you going to do a friends and family pass the hat where you're doing maybe common equity, right. And you're collecting $25,000 here, $50,000 there, or you looking at a safe or a convertible note? Those are kind of the probably the two primary methods we see for early stage companies and figuring out how to structure those. Right. Is it a pre money safe? Is it a post money safe?

30:58
Daniel Scharff
Let's get into all of these terms. Can you take a like again, I'm 10. What is that?

31:03
Adam Marsh
So a pre money safe, right, that it converts. The safes convert along with all the other money. So usually when you do a safe, the safes convert when you do a preferred round of financing, right? And it'll be a cap and a discount. So the cap could be. Call it $10 million. So with the pre money safe, though, the investor doesn't love it because they don't know exactly what their safe is going to convert into because they convert at the same time as all the other safes along with the new money. But a post money safe says, suppose you put in a $10 million valuation and you put $2 million in the company. That investor knows at the time of conversion that they're going to own 20% of the company. So they love that because they have certainty into what the future looks like.

31:51
Adam Marsh
Whereas with the pre money safe, there's certain calculations that you have to use to determine how much your $2 million investment is going to result in equity at the time of the grant.

32:03
Gabrielle McGonagall
And one thing, just to add even more kind of like lower level detail, the SAFE and the convertible notes, those are sort of like your key debt instruments. Which means when you're investing, you're not on the cap table yet. You don't actually own equity. You're basically giving the company a loan and saying, we're going to invest, we're going to give you this amount of money. And once you do your next raise, depending on the terms of that's when we'll then get issued our equity. So it's sort of kicking the can down the road, right? If you don't yet have, you know, a lot of sales to back up evaluation. So you don't want to say like, hey, we're, it's going to be $5 a share based on what valuation are we looking at?

32:43
Gabrielle McGonagall
So those debt instruments are great when you're not quite at the point where you're able to assert like kind of peg a value, but you're still giving people future value based on future performance.

32:56
Adam Marsh
And the safe is called a simple agreement for future equity. It doesn't have an interest rate or like default mechanisms like a convertible note does. So, you know, 10 years ago when I started, convertible notes were all a rage. But I'd say, you know, in the past five years, safes have become more popular because you don't have to tie an interest rate to it. You don't have to, you know, there's no defaults in case you can't pay off your other existing debts. There's no maturity date. So there seems to be a shift towards safe just because they're more flexible.

33:29
Daniel Scharff
Okay, so just to clarify all that a little bit more. So, okay, with a pre or post money safe, basically I'm saying there's not really a valuation on the company. I'm just going to give you a certain amount of money as debt, basically on the business. And then when you eventually do evaluation and a raise, it's going to convert into equity and there's a discount, which means whatever that valuation is, I get a discount to that because I'm giving you the money today, not at the time that you actually do that raise. And then there's a cap, which I think means the maximum valuation that you could have on a business at that Point.

34:09
Gabrielle McGonagall
So it's not a cap on what the valuation is, but it is going to be a cap on the conversion calculation. So, you know, if there are a million units outstanding and the company's worth $10 million, the price per unit's going to be $10 per unit. If the safe said basically you're going to the cap is 10 million, that's going to be your conversion rate. So it doesn't limit the company at raising it a higher value. It just impacts the cost at which or the price at which the safe will convert. It's investor protection.

34:42
Daniel Scharff
Okay, so it's investor protection. Does it also protect the company? Because I'm just thinking like, does it mean if they wait longer to raise versus less amount of time that you actually end up getting a different amount of the company or it's somehow protected from that because of the cap?

34:58
Gabrielle McGonagall
The goal always is that the longer it takes to raise money, the higher the valuation is going to be. So more often than not, you know, if we had a safe right now that had a $10 million cap because maybe right now our valuation is more like 5 million. So we're like, great, you'll have a $10 million cap if this converts in 18 months, which is the next time we're going to do a raise. That's kind of the ballpark figure that we're thinking. We're going to raise that if the company at that Stage is worth 40 million, the company is going to be a lot more or the existing shareholders are going to be a lot more diluted by the fact that it's converting at a 10 million valuation than they would if it was converting at a $40 million valuation.

35:41
Gabrielle McGonagall
So the cap doesn't really give the company protection. And in fact, some really early stages, we do a safe with a discount but no cap because we're sort of like we have no way of knowing how this is going to convert, when it's going to convert, and what number even makes sense. Most investors insist on some sort of cap because it gives them some kind of baseline protection on that conversion pricing.

36:07
Daniel Scharff
Okay, I gotcha. And then tell me again, safe versus convertible note.

36:12
Adam Marsh
All right. Safe simple agreement for future equity. There's no maturity date, there is no ways you can really default, and there's no interest rate. Maybe most importantly, right? So if you're doing a convertible note with a million dollar convertible Note and a 10% interest rate, right. That interest rate gets included in each note holder's calculation of what they should get when they convert into equity so.

36:38
Daniel Scharff
Does that mean as like company, Probably I want them to be on a safe, not a convertible note. Because a convertible note they're going to start increasing the ownership that they have. Like, you know, as I wait.

36:49
Gabrielle McGonagall
Not only that, but the maturity date is actually a big one because most have probably a maturity date of two years. Convertible notes. And what convertible notes usually say is you'll convert upon a company sale of qualified financing, which usually has some sort of threshold, you have to raise 5 million at least to convert this or if you haven't done either of those things, you either have to convert us at a price that we that sort of negotiated or you have to repay us. So the last thing you want is, you know, you take on $3 million in convertible notes, you hope in the next two years to be able to do a fundraise, you're not able to get the funds to actually convert these.

37:32
Gabrielle McGonagall
Then you have a bunch of note holders two years later who are looking for their money back and you don't have the money to pay that. The safe totally avoids that because they don't have this sort of drop dead date of when this thing has to move. So a safe could be outstanding for as long as it takes until the company make some sort of major corporate transaction.

37:53
Daniel Scharff
And so crowdfunding is something that a lot of people are looking at right now, I think because it's so hard to get that nice VC money. So I also want to ask you about crowdfunding. It's something that a lot of founders are looking at now. What's the story there? How does that, what are the implications for the structure and all the other equity and everything?

38:10
Adam Marsh
Yeah, I mean crowdfunding has been around for a while. Like circle up was doing it years and years ago. And we see all different platforms. The issue with crowdfunding is kind of twofold. One, it means you have a ton of people on your cap table, right? So you know, if you're accepting $5,000 from me and 20 other people, that just makes your life difficult because you have 20 people on your cap table and that Number could be 100 people on your cap table. So that's just like a corporate governance pain. And then second there, you know, you just have to really review those documents carefully. There's a lot of hazards in there. There's a lot, you know, there's some ways you can protect about having a hundred people on your cap table.

38:52
Adam Marsh
You can put in like a voting proxy saying the CEO can vote their shares, but without like really drilling down on those documents and making sure that they comply with applicable law. And just like good corporate governance, it can be problematic. But at the same time, like, we get it, like, it's a tough time to raise money right now and sometimes you have no other option. So, no shame in the crowdfunding. You just have to go into it with your eyes wide open.

39:21
Gabrielle McGonagall
Yeah. I think one other point there is just it does have a certain signal to other investors. I think if it's really early stage and it's like kind of your initial starting point, then it's sort of like, hey, we didn't want to negotiate terms with a large strategic and give away a bunch of rights. So we did sort of a minimum crowdfunding effort one year in. I think if you're a company that's been operating for a couple of years, you have investors who have money on your cap table and then you are moving to a crowdfunding, it may signal sort of a lack of confidence in your existing investor pool and also a lack of new interest in more strategic, larger sort of VCs.

40:05
Gabrielle McGonagall
So something to also just keep in mind what the messaging is not only for the investors who have been on board, but also people who may be looking to acquire. Come on. Later.

40:14
Daniel Scharff
Okay, cool. So another thing I want to ask you about is we always see these movies and read these stories about people losing their companies because they raised the wrong way and, I don't know, somebody made them sign a document they didn't understand, and all of a sudden they're kicked out of their own company. So let's say what we're trying to do here is make sure the founder understands all this stuff and can protect themselves. How should they structure these, like, term sheets and their fundraising and, you know, what are the rights that investors are going to want to have? What do we need to watch out for?

40:46
Adam Marsh
I think the key is hire a good lawyer. No, I'm kidding. But do surround yourself with people that understand the industry. Right. Again, we only represent founders, so we go to bat for founders day in and day out. But the private equity funds, they might say, you know, they love XYZ founder, but they don't have their best interests at heart because they have their own fiduciary obligations to their investors. Right. So what you need to do is make sure you control your board for as long as possible. And even if you don't control your board, maybe you have some limited blocking rights in there that says, you know, hey, XYZ investor, you can't sell this company without my approvals. The other thing is you really just need to negotiate the governance of your company. We talk about these MVCA forms.

41:33
Adam Marsh
They have a list of blocking rights, and a blocking right are kind of negative controls over what the founders and management can do for the company. So if you give away a bunch of blocking rights in your first investment, you're kind of going to be stuck because the next investor is going to want those same blocking rights and more. And then, you know, these companies are all entrepreneurial. Like, you got. You want to move fast, right? You have to make decisions quickly. But if you have to call a board meeting for every decision that you have to make, you're going to be hamstrung and it's going to be hard for you to move fast and be nimble and agile and make decisions quickly that will drastically impact your company.

42:11
Adam Marsh
So the key is to be cognizant of, you know, what the investors will want and what you need to properly run a company in the way that you know and see fit.

42:22
Daniel Scharff
So I think for a lot of founders, it's like hard to really focus on a lot of these issues because you're like, oh, that's like, that's late company stuff. Like, I hope I have that kind of a problem because it means I'm big enough where, you know, people want to take my company from me. But it sounds like at the early stage, like, you really do need to know about this stuff so that you are cognizant of it to make the right choices and structures because that it like the course really does like you're going to be on the same course. If you make one bad decision, it's just going to compound into all the rest of them. Is that, does that sound right or do you see a lot of these fights happen even at the early stages?

42:57
Gabrielle McGonagall
No, I think one thing that we always kind of caution our clients, again, if you can do those friends and family pass the hat common rounds early, those people are not asking for those rights. Doing the safe or the convertible note, again, kind of kicking the can down the road of when you're getting those strategic partners in who are going to look for those controls. I think the other two big points are one, kind of like Adam's saying, these founders want to move so quickly. We get that and they think, let's get through the term sheet stage and then we'll deal with it later.

43:30
Gabrielle McGonagall
It's the biggest miss we see, not negotiating these points and really figuring out where you stand with these Investors at the term sheet stage not only is crucial in terms of like setting the stage for your go forward relationship, but it takes way more time and costs way more money to argue those things, make revisions, pass back and forth, drafts at the long form stage. And so I think there are a lot of founders who don't want to rock the boat at the term sheet stage. You know, they need capital, they don't want to seem difficult, they don't want to seem like they're doubting these partners. That's really not what it's about. It's about making sure that they're protected. It's also why we often are like, well, just let us be the bad guys. We'll go in and negotiate in.

44:15
Gabrielle McGonagall
We'll say all the things that you don't want to say. Sometimes it's hard when you're worried about preserving the long term relationship to like really fight for certain points that are important. And like Adam said, you know, at the beginning, it's a love story like Angel PE company that comes in, they love your product, they love your vision, they love what you're doing. Of course they want you at the helm and of course they agree with the way you're doing things. That's why they're so excited about this. It's when things aren't going well that you see those negative controls implicated. So it's easy when you're at the term sheet stage with rose colored glasses to kind of not want to really do the nitty gritty hard conversation about what these blocking rates actually mean. But it's crucial.

45:00
Gabrielle McGonagall
And then I think like Adam said, with like talking to people you can really trust, there are a lot of those blocking rights that don't seem like they're ever really going to be a problem, but they're kind of what we call like a backdoor blocking. Right? So for example, one is like increasing the size of the board. You might think this, we have our board, it's great, everything's going well. If you do a senior raise, whoever the lead investor is in that raise is going to want a board seat. So while this investor isn't saying you can't raise senior money, if you're raising senior money, they're going to want a board seat and now they have a block over that. So I think it's also really important to understand all of the implications of these different blocking rates.

45:40
Gabrielle McGonagall
Rather than just sort of seeming like, this looks okay, this isn't going to come up.

45:44
Daniel Scharff
Okay, I gotcha. And speaking of raising more money. What can I do to try to protect myself against dilution? As I start raising the money and my equity starts dwindling down, how can I try to keep as much of it as possible?

45:58
Adam Marsh
That's a great question. And unfortunately, like, that's just part of the nature of the industry, right? As you raise more money, you're going to get diluted. So the key is to only raise money when you. When you absolutely need to, but also starting that process early, like we discussed earlier, so that you don't lose all of your leverage. Right. Once you. Once you're going to, you know, run out of money in two weeks, you lose a lot of leverage in the negotiations. And then, you know, hopefully you found good partners that. That realize now, Daniel, you shouldn't be at 35%. You still grind every single day. No, let's bump you up, issue stock options so that, you know, you get up to 40, 45%. So now that's part of having a good partner, part of the negotiation structure.

46:41
Adam Marsh
But unfortunately, like, the reality is, dilution is going to happen. The key is to try to prolong or to withstand that for as long as possible.

46:49
Daniel Scharff
Who are these mythical, amazing investors that just try to give you more money? I want a list of all these people.

46:57
Adam Marsh
Yeah, they do exist. It usually doesn't happen for, you know, a founder who's been working for four years. It's the guy who's been doing it for eight, nine years who's really suffered dilution, but who is in the role to the company. And, you know, this is their baby. And, you know, you hope you find partners that want to reward that hard work.

47:17
Gabrielle McGonagall
I think the other thing is being really particular when you're issuing incentive equity early on, whether it's profit, interest, grants, or whether it's stock options. It's really easy when you're early stage and you're like, I don't really have a lot of what's 1%, what's 0.5%, what's 2%? Those things really do add up over time. So making sure when you're doing that in connection with services or certain performances, you time that vesting to the performance. If Adam ends up with 5% because he did everything that the company needed him to do, and it was a rocket ship. Great. He gets 5% of something that we've all got a lot of value from. If he gets a grand for 5% and he hasn't driven any value, that 5% dilution that the rest of the shareholders feel hurts A lot more.

48:03
Gabrielle McGonagall
So I think also being really conscientious about how and when you're issuing equity outside of an investment and kind of the parameters around that and how to make sure that people aren't holding an ownership stake who haven't really earned that ownership stake.

48:18
Daniel Scharff
All right, that makes sense. So, and one other thing I want to ask about is like I've heard about secondary sales, which is I think where, okay, you start the company, you have all that equity, you raise some money, you know, maybe at some point you don't have to just be a starving founder, right. Like you are building this thing that people think is going to be successful. You don't have to wait to eventually sell it. Someday you can actually sell some of your shares and get some money so you can pay off your student loans or get a house or you know, just like live a little bit better. Maybe you have kids, they need to go to school, all that kind of stuff.

48:52
Daniel Scharff
Like how does that really work and does it always seem appropriate when that happens or do people push back on it?

48:58
Gabrielle McGonagall
I mean, you talk about myths, it doesn't happen as often. I think it's like one of the bigger hype dreams. Adam, I think you probably.

49:08
Adam Marsh
Yeah, I mean, you see it, right? But again, it's those founders that have been doing it for seven, eight, nine, ten years. And to your point, you know, it's often proposed by an investor, right. Or the company's doing so well that the company doesn't really need money, but you have an outside investor wanting to come in, be along for the ride. And in doing so, they can provide liquidity to the founders. But again, that's more on a, you know, that's a well developed company, that's EBITDA positive driving revenue. Those are the types of scenarios where that happens. Now, I wouldn't expect to see that near 2 or 3, 4 or 5. And, and I don't think a founder, I would recommend against a founder really asking for it in those early stages.

49:50
Gabrielle McGonagall
Yeah, I think the place we see it the most is when you have a strategic who loves the product and they say like, hey, we want a 15% stake. And the company's like, we don't need any money. We're like, we're doing great and they want to come in for a 15% stake and maybe also then negotiate a right of first refusal on a sale or something like that. So it's really more in scenarios where it's like kind of a unicorn than anything you should be banking on, like, I'll put in four or five years and then maybe I'll get. I'll be able to sell some of this off to an investor. That doesn't typically happen.

50:25
Daniel Scharff
All right. I don't know if you can hear that, but that's the sound of you guys crushing a lot of people's dreams right there. A lot of people who thought they could cash out, at least some in like, year two, three. So.

50:34
Adam Marsh
All right.

50:34
Daniel Scharff
It's good for everyone to know.

50:37
Adam Marsh
So.

50:37
Daniel Scharff
All right, last question I think we could end on is we are living in the age of AI and people being scrappy and what can we all get done on our own using our ChatGPT friend? And what do we. Where are we really going to benefit from having people like you guys who have worked with so many clients and obviously have just seen all the stuff play out? What do you think?

51:03
Adam Marsh
Yeah, I think, you know, AI has its per. It has its purposes and its role. Nothing can substitute experience, right? Nothing can substitute negotiating those blocking rights on a term sheet against the private equity team that you've dealt with 10 times before. Or like, maybe a distribution agreement, right? Like, I don't know if ChatGPT knows what the proper multiple on a termination of that agreement for causes. So I get it. Companies in this industry were lean and mean and they don't have a bunch of money to spend on attorneys. But the key is to, you know, find those areas where you might have a blind spot, right? Whether it's fundraising, whether it's building up a distribution network and leaning on whether it's a lawyer or advisors for those things. Because the reality is like, you know, you don't know what you don't know.

51:56
Adam Marsh
And you might have a great trust in the state's attorney, but he doesn't know the first thing about, you know, a manufacturing agreement and what the proper take or pay mechanism should look like. And I don't know if Chatbot knows that. Maybe it does. I haven't tried. But that the asset building, the backbone of the company, that getting those governing documents right, that are going to, you know, govern how you and your partners work for the next four years, like those critical agreements, you know, you should rely on someone with industry knowledge now, whether it's advisor, someone who's exited before another founder or a lawyer.

52:33
Gabrielle McGonagall
And one other thing on that, I would even say, you see that in kind of the work that we do, and there are a couple of other firms that are in sort of CPG more heavily, we work with across the table from, you know, the white shoe law firms, the big names, very expensive. We've had clients come from those who are using great, sophisticated, smart lawyers, but who don't know cpg. And so all legal documents are not the same. There's. There's a framework. But like Adam said, you can't kind of make up for the real expertise that. That you only get from having done this and only doing this for as long as we have.

53:13
Daniel Scharff
That makes sense to me. So, yeah, I mentioned my sister who is a lawyer, and I always try to ask for free legal advice. Is she, you know, she like, is basically in house somewhere now. She usually will be like, okay, put it into chat GPT and then send that to me and she'll look at it. Then she's like, all right, it missed like, okay, yeah, you can use this, like, basic structure. That's not bad language. But it missed like three big things, and you are going to want those in there. And she's right. I'm like, oh, yeah. Like, it didn't. It did not know about those things. Sometimes I don't know why. Like, it seems like there's some just standard stuff that it should have accounted for. Like, it should have. I don't. It wasn't even particular to me.

53:51
Daniel Scharff
It just should be accounting for that stuff in contracts and then other stuff where, like, even if it knows you a little bit, it's not going to know a lot of contextual things that it should be asking you about your business and your plans and what kind of things could happen in your kind of a company or industry. So probably, yeah. Anyways, probably saves her from starting from scratch on a bunch of language. But just the, like, judgment and stuff, it's hard to imagine it getting there.

54:17
Adam Marsh
Cool.

54:18
Daniel Scharff
All right, team. Thank you guys so much for joining us today. I definitely learned a lot and reminded me how little I know. So thank you. I think that's why we all like to work with lawyers. You make all the hard stuff. Okay? So thank you both very much. And Adam, I will see you at the gym since we both go to the same gym here. Equinox. Equinox Greenwich Shout Out. So I'll see you bright and early. Maybe you'll catch a sighting of the celebrity I've been seeing there a bunch lately, which is Bob Odenkirk, better known as Saul, Better Call Saul. And fun fact, he can do way more pull ups than I can do. He's in there just ripping pull ups. He's here in New York. He's doing Glengarry Glen Ross.

55:01
Daniel Scharff
I think it's a 12 week showing that they're doing on it, which I saw last week. It was awesome. He's doing good work in there. And he wears sunglasses also that like, will make him look kind of like a weirdo. Everyone's like, what's up with that dude? Like, no, that's the big time dude in here. All right, so well, we can both harass him next time and try to get a selfie with him. All right, thank you guys. Really appreciate your time. All right, everybody, thank you so much for listening to our podcast. If you loved it, I would so appreciate it if you could leave us a review. You could do it right now. If you're an Apple podcast, you can scroll to the bottom of our Startup CPG Podcast page and click on Write a review. Leave your company name in there.

55:41
Daniel Scharff
I will try to read it out. If you're in Spotify, you can click on about and then the star rating icon. If you are a service provider that would like to appear on the Startup CPG podcast, you can email us@partnershipstartupcpg.com lastly, if you found yourself grooving along to the music it is my band, you can visit our website and listen to more. It is superfantastics.

56:05
Adam Marsh
Com.

56:06
Daniel Scharff
Thank you everybody. See you next time.